Disclosures in Illinois’ bond offering statement represent “characteristics of a credit under stress,” said Richard Ciccarone, president of Merritt Research Services.

CHICAGO – Illinois' first bond offering statement in 20 months prominently lays out a trove of warnings about the state's stressed fiscal condition, from failed pension reforms and budget gridlock to its weakened credit and negative swap valuations.

Illinois, which in 2013 settled fraud charges brought by the Securities and Exchange Commission for misleading pension disclosure between 2005 and 2009, outlines for investors its current fiscal mess as it prepares to offer $480 million of general obligation paper in a competitive sale Jan. 14.

"Particular attention should be given to the investment considerations described below which, among other things, could affect the financial condition of the state and therefore result in a repayment risk for investors, and could also affect the liquidity/market value of the bonds after they are issued," the offering statement warns.

The bleak disclosure runs counter to the investor presentation that accompanies the offering statement, in which the state's finance team seeks to allay investor concern by highlighting the state's economic strengths and strong GO structural protections.

They also point to several political accords they say show current leaders have demonstrated "political will" despite their inability to produce a state budget.

"The budget impasse highlights the importance of the protections" that give GO repayment priority over most other state expenses, state capital markets director Kelly Hutchinson told potential investors. "We believe the state has ample liquidity in order to make its debt service payments and it is a top priority for the state."

The state's woes stand to dent that perception.

"Investors have hung their hat on the state's GO security provisions," said Richard Ciccarone, president of Merritt Research Services. The list of pressures outlined represent "characteristics of a credit under stress" that "present serious concern for a long term bond buyer," he said.

Topping the list of investment considerations is the budget, more than six months overdue amid an impasse between Gov. Bruce Rauner, a Republican who took office last year, and the General Assembly's Democratic majorities. The Democrats won't accept Rauner's demand that his governance and policy proposals be part of the budget discussion.

"The state's financial condition has been materially adversely affected by the budget impasse," says the offering statement which additionally warns that the bill backlog is expected to grow significantly. The state comptroller's website currently reports $3.9 billion of payables and an additional $3 billion in bills being held back by state agencies.

A second risk item outlined is the loss of tax revenue after the partial expiration of a 2011 income tax hike last January. Personal rates dropped to 3.75% from 5% and corporate rates declined to 5.25% from 7%, resulting in an estimated loss of $4 billion to $5 billion annually.

Another risk detailed is the May 2015 Illinois Supreme Court ruling striking down the state's 2013 pension reform package that aimed to reduce the state's now $113 billion of unfunded obligations and its hefty contribution requirements – estimated at about $7.8 billion in fiscal 2017.

"The state's financial condition is now materially worse than the state's anticipated financial condition" if the reforms had been upheld, the offering statement says.

Another pressure stems from the state's requirement to repay by December 2016 $454 million borrowed from non-general fund accounts to help close a fiscal 2015 shortfall.

Additionally, liquidity and bank risks are posed by the state's $600 million of floating-rate paper from a 2003 issue, although the variable-rate debt represents just a small piece of the state's $26 billion GO debt portfolio.

The paper is supported by six direct pay letters of credit that expire on Nov. 26. The support is provided by JPMorgan Chase, PNC Bank, Wells Fargo Bank, State Street Bank & Trust Co., Royal Bank of Canada, and The Northern Trust Co. JPMorgan and Wells Fargo serve as remarketing agents.

The $600 million is synthetically swapped to a fixed rate of 3.89% through five interest rate agreements that are negatively valued at $143 million.

The counterparties are AIG Financial Products Corp., Bank of America, Merrill Lynch Capital Markets, JPMorgan Chase Bank for $54 million each with the fifth for $384 million with Loop Capital/Deutsche Bank AG. The latter is negatively valued at $92 million and the negative values of the others are between $12 million and $13 million.

Termination events are triggered if a rating is withdrawn or suspended or Standard & Poor's drops the state to below BBB or Moody's Investors Service drops it below Baa2. S&P rates Illinois A-minus with a negative outlook and Moody's rates it Baa1 with a negative outlook.

In the investor presentation, the state's finance team highlights state strengths.

While state general fund revenues of $35.9 billion in fiscal 2015 are down from $36.8 billion in fiscal 2014 due to the tax rate change, the state collected $500 million more than previously expected. The state was further able to reduce its bill backlog by $583 million during fiscal 2015 bringing it down to $3.5 billion. Its steep rise since then is due to the fiscal 2016 budget delay.

The big issue is that Illinois does not have a fully enacted fiscal 2016 budget, said Office of Management and Budget Director Tim Nuding.

"We do have six months to rectify" the current budget deficit," he said.

Nuding also highlighted the political accord on several issues including resolution of the fiscal 2015 deficit, approval of legislation authorizing the spending of federal dollars, and the recent approval of legislation freeing up $3 billion. The latter allows lottery winners to be paid and gas taxes to be distributed to local governments.

The legislation also appropriated funds for payment on the state's Civic Center bonds and a small amount of certificates of participation. Nuding stressed that the state had backup plans to cover any debt service in the absence of the legislation and calls the three agreements examples of the legislature and governor working together.

Those agreements are overshadowed by the larger budget impasse and inability to tackle the state's pension woes.

"Political will is a core issue" for investors looking at state GOs, Ciccarone said.

The state has $26.5 billion of GOs outstanding, including $13.8 billion for capital and $12.7 billion of pension-related debt.

The state sale is expected to benefit from investor hunger for yield.

Illinois saw spreads to the Municipal Market Data top rated benchmark for 10-year paper of between 95 basis points to 110 basis points on its 2014 sales but secondary market spreads have hovered between 170 to 180 basis points recently.

Since its last GO bond sale Fitch Ratings and Moody's have downgraded Illinois, from A-minus and A3 respectively to BBB-plus and Baa1. Fitch assigns a stable outlook, Moody's a negative one. Both rating were affirmed last month.

Standard & Poor's affirmed its A-minus GO rating and assigned a negative outlook, after removing the rating from CreditWatch with negative implications.

Chapman and Cutler LLP and Pugh Jones & Johnson PC are bond counsel on the deal and Public Financial Management Inc. is advising the state.

The offering statement reports that the state may seek to undertake a cash flow borrowing and will return $44 million collected from retirees in 2014 and $19 million this year under a retiree healthcare subsidy settlement. The settlement followed the high court's opinion that state constitutional pension protections extend to retiree healthcare subsidies.

The offering statement reports that as the state rating falls, fees of the credit providers and interest rates on any advances adjust.

Proceeds of the 25-year bonds will finance ongoing state infrastructure projects.

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